A guide to future financial scandals – and how to prevent them

October 5, 2006

By David Callahan

NEW YORK

This has been a good autumn in the battle against corporate crime. From the prison sentencing of WorldCom and Enron executives to the public outrage over the HP spying scandal, Americans who've felt injured by corporate malfeasance must be glad to see justice being done.

But even as these scandals fade into the rearview mirror, we must focus on the road ahead. More business scandals are likely, and they will probably be very different in nature.

Like generals, government watchdogs tend to fight the last war – not plan for the next one. After Enron's collapse, Congress passed the Sarbanes-Oxley Act to stop companies from cooking their books, which is all well and good. But there is a high possibility that future financial corruption won't involve earnings fraud of the kind we saw in the in the past decade. Consider where the next scandals might come from:

Hedge funds

Thousands of hedge funds now manage about $1.5 trillion and yet remain largely outside the purview of regulators. These investments engage in heavy borrowing and leveraging – dangerous tactics that almost derailed the economy back in 1998 when a large hedge fund, Long-Term Capital Management, imploded. Today the potential for such disaster – not to mention major rip-offs of investors – is far greater, given that hedge funds control far more money than they did in 1998. Recently, the fund Amaranth lost $6 billion. Despite the growing risks, regulators have mounted no serious efforts to better control these entities.

Real estate

Some $2 trillion in new mortgages are ori-ginated every year, and housing wealth is increasingly central to the economic security of American families. But by most accounts, the mortgage industry is woefully under-regulated. The key gatekeepers in this area – the appraisers who determine property values – remain haphazardly overseen by small state agencies, while mortgage brokers are often not regulated at all. Evidence of widespread fraud is mounting, and worries are rising that too many bad loans could accelerate the decline of housing prices and hurt the economy. Still, government has done little to tighten rules and bolster enforcement.

Insurance and healthcare

The trillion-dollar insurance sector remains poorly regulated by tiny state agencies, despite revelations in 2004 that price fixing by industry giants had cost consumers millions of dollars. The $2 trillion healthcare industry also remains rife with fraud, with some estimates pegging the annual cost at nearly $100 billion.

Defense contracting

This sector seems headed for a new round of scandals, perhaps comparable to the corruption exposed during the 1980s. In Iraq, whistleblowers have filed dozens of lawsuits alleging contracting rip-offs.

Enron's collapse, and all the other scandals, should have brought the curtain down on the Wild West mind-set of that era. This clearly hasn't happened and corruption continues to percolate in many sectors of the business world.

Instead of again learning the hard way where the opportunities for fraud and abuse exist, Congress needs to get ahead of the curve. The Amaranth meltdown should be a wake-up call about the dangers of hedge funds and spur efforts to regulate these entities, as some in the Securities and Exchange Commission have proposed. Also, Congress needs to rethink its recent preference for leaving many regulatory matters up to the states. Clearly, many state agencies lack the ability to stand up against such powerful industries as real estate, insurance, and healthcare.

The federal government hasn't been too popular in recent decades, thanks in part to a steady stream of antigovernment rhetoric. In the wake of the corporate scandals, though, it should be crystal clear just how important it is to have a government that can protect citizens from rogue businesses. The question now is whether we have really learned our lesson.

• David Callahan is the author of "The Cheating Culture: Why More Americans Are Doing Wrong to Get Ahead." His new book is entitled "The Moral Center."